Artificial Intelligence for Trading
What is Artificial Intelligence?
To understand the application of Artificial Intelligence in capital markets, we must first dive into the definition of Artificial Intelligence. Artificial Intelligence is intelligence developed inside the machines with the use of huge datasets and training models with the help of which, the machine in return, helps find out hidden patterns and gives predictions based upon the inference. Artificial Intelligence is a valuable tool with the help of which manual labor as well time could be saved and if applied correctly, can provide exceptional results.
What drives the price of an asset?
Irrespective of the market, be it a capital market, commodity market, or forex market, the factors that determine the prices are common to all. There are numerous factors that cumulatively lead to the determination of prices, but the two most important ones are value and sentiments.
The value that a stock, commodity, or currency holds, and the current market sentiments are broadly the two main factors that determine their price. (Note: Here the term value is determined using the fundamental analysis of the asset and not the sentimental value.)
How trading was done before the inception of Artificial Intelligence?
Till the early ’80s, people used to trade on a stock after performing the fundamental analysis (using balance sheets) or technical analysis (using charts and patterns).
Fundamental Analysis was performed using the balance sheets of a company wherein sales, profit/loss et cetera were looked at carefully along with some financial ratios namely, P/E(price/earnings) ratio, P/B (price/book value) ratio, EBITDA (earnings before interest, taxes, depreciation, and amortization) et cetera.
Technical Analysis on the other hand was performed after viewing price movements on stocks every day and plotting them in the form of charts, based on which a trader after analyzing patterns, develops a view of the stock going up or down.
Both methods are discretionary in their implementation and are being used successfully to trade even now.
The rise of Artificial Intelligence for trading
The rise of Artificial Intelligence was preceded by automation, since people had to manually punch in the orders, for a huge amount of volume, the process became a little cumbersome, and people decided to automate the process of punching orders. After this, people started to think about the further implementation of technology in the field of capital markets. Various attempts were made to enhance the trading systems with the use of technology and then came a trader who transformed the traditional approaches to the stock market by making the highest returns anyone has ever made until now with a Compounded Annual Growth Rate of 71.8%. This trader is none other than Jim Simons, the owner of Rentech (Renaissance Technologies). Simons, with the help of top scientists and researchers in the world, used quantitative analysis and artificial intelligence to go through historical data and detect anomalies in patterns that would not occur at random. This proved to be a tremendous success and artificial intelligence in financial markets started gaining traction.
Applications of Artificial Intelligence in today’s financial markets for trading
There are numerous ways in which Artificial Intelligence is being implemented in today’s financial markets. There are three ways in which Artificial Intelligence is being used today: Optimization of portfolios, analysis of sentiments, and the prediction of prices of an asset.
Optimization of portfolios
Also known as Portfolio Selection, is an issue that involves identifying the optimal selection of financial assets for a certain investor, with the goal of maximizing earnings.
Markowitz’s Modern Portfolio Theory (MPT) was one of the first methods to be adopted to optimize the portfolio with the help of two parameters reward and risk involved which is also known as the risk is to reward ratio.
Analysis of sentiments
As mentioned earlier, sentiment plays a very important role in the determination of the price of an asset. The cumulative emotions of people determine whether there is greed or fear in the market and based on this, the price of an asset is predicted. There are various AI tools that collect information available on the web in the form of news, articles et cetera and provide the overall score that predicts greed or fear in the market. Sentimental analysis is widely being used in a variety of fields of knowledge, including computational finance.
Prediction of the prices of an asset
The use of quantitative analysis with the help of Artificial Intelligence is being used to determine future price predictions. Historical data is collected and then processed in order to detect patterns or flaws in patterns and based on these patterns, predictions of the prices are made.
Conclusion
Artificial Intelligence has proved to be a boon in the field of financial markets and is being widely applied through algorithmic trading. In the USA, nearly 70% of the entire trading volume is generated through this method, whereas, in India, it is approximately 40%, and the percentage is increasing year by year. The use of Artificial Intelligence and automation will become a necessity in the field of trading in the near future, whereas discretionary trading will see a gradual decrease in its application. Therefore, it is better to adopt new methodologies using artificial intelligence and develop an edge in trading financial assets.
